Lyn Alden

Stocks have continued their wild ride into December, as uncertainties abound about the likelihood and details regarding a potential U.S. and China trade agreement, as well as general concerns about slowing economic growth in the United States and the rest of the world.

For the full month of November, all of the funds except the I Fund were in positive territory. The G Fund was up a small fraction of a percent as usual, while the F Fund was up a solid 0.6%. The C Fund was up 2%, the S Fund was up just under 2%, and the I Fund was down a tiny fraction of a percent.

During the first week of December, this quickly reversed for the equity funds. The C Fund was down 4.5%, the S Fund was down 4.8%, and the I Fund was down 2.8% for the first week of December. The G Fund was up slightly, and the F Fund was up over 0.8%.

According to Yardeni Research, 90 years of data show that December is the month that is most likely to have positive returns for the S&P 500. Over 73% of Decembers going back to 1928 have had positive returns. So, this is quite a rough start to what is usually one of the more peaceful months of the year.

The Yield Curve Started to Invert

One of the big pieces of financial news at the beginning of last week was that the U.S. Treasury yield curve began to invert for the first time in over a decade. More specifically, 2-year and 3-year Treasury bonds now have a higher yield than 5-year Treasury bonds, whereas usually longer bonds have higher yields:

Source: Department of the Treasury

During periods of healthy economic growth, usually the yield difference (curve) between long-term bonds and short-term bonds is large. As the economy begins to hit its cyclically peak, the yield difference historically starts to flatten out and eventually invert.

An inverted yield curve has preceded all U.S. recessions in the past half-century. This chart shows the yield curve, measured by the difference in interest rates between 10-year Treasury bonds and 2-year Treasury bonds, with recessions shaded in gray:

Source: Federal Reserve Bank of St. Louis

The link between yield curve inversions and recessions goes back even further than this chart.

Fortunately, the 10-year yield still hasn’t quite inverted under the 2-year yield, although the difference is only about 0.13%. Only the middle of the yield curve has inverted as of this week, involving the 2-year, 3-year, and 5-year bonds.

The good news is that usually there is a delay between a yield curve inversion, the peak of the stock market, and the start of a recession. For the past six recessions, it has taken over 9 months on average for the stock market to hit a peak level after the yield curve inverts, and another 5 months after that for a recession to begin.

This is highly variable though, because every market cycle is different. Half of the time, the market peaks during or shortly after yield curve inversion, while other times it has taken almost two years for the market to peak after a yield curve inversion.

If the Federal Reserve goes forward with its expected December 0.25% interest rate hike, there’s a solid chance we will see the 10-year yield invert under the 2-year yield. What exactly that means for markets over the next year or two is anyone’s guess, but the data suggest that people should be positioned cautiously at this time while we are likely late in the market cycle.

It’s a good time to make sure your portfolio asset allocation is aligned with your goals, age, and risk tolerance, that you have a strong household balance sheet while times are plentiful, and that you have enough cash liquidity to ride out a potential furlough or other unexpected events.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.